MA(BS)3(IIIc) /P.1 (03/2016)

Completion Instructions

Return of Capital Adequacy Ratio Part IIIc – Risk-weighted Amount for Credit Risk

Internal Ratings-based Approach Form MA(BS)3(IIIc)

Introduction 1. Form MA(BS)3(IIIc) (“IRB return”) of Part III should be completed by each

authorized institution incorporated in Hong Kong (AI) using the internal ratings-based approach (IRB approach) to calculate credit risk under Part 6 of the Banking (Capital) Rules.

2. These completion instructions contain the following four sections:

Section A General Instructions Paragraphs

I Scope of the IRB return 5-6

II Classification of exposures 7-8

III Choice of IRB calculation approaches 9

IV Structure of the IRB return 10-12

V Definitions and clarification 13-40

Section B Calculation of Risk-weighted Amount for Credit Risk under IRB Approach

I Risk-weighted amount under IRB approach 41-45

II General requirements for all IRB classes 46-54

III Specific requirements for certain exposure portfolios 55-58

IV Corporate, sovereign and bank exposures 59-107

V Retail exposures 108-117

VI Equity exposures 118-133

VII Other exposures 134-135

VIII Purchased receivables 136-141

IX Leasing transactions 142-143

X Securities financing transactions 144-151

XI Credit-linked notes 152-153

XII Calculation of risk-weighted amount of off-balance sheet exposures

154-185

XIII Credit risk mitigation 186-232

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XIV Application of scaling factor 233-234

Section C Treatment of Expected Losses and Eligible Provisions under IRB Approach

I Determination of total EL amount 235-238

II Determination of total eligible provisions 239-242

III Treatment of total EL amount and total eligible provisions 243-245

Section D Specific Instructions

Form IRB_TOTCRWA 246

Form IRB_CSB 247

Form IRB_SLSLOT 248

Form IRB_RETAIL 249

Form IRB_EQUSRW 250

Form IRB_EQUINT 251

Form IRB_EQUPDLGD 252

Form IRB_EQUO 253

Form IRB_OTHER 254

Form IRB_FIRBLGD 255-256

Form IRB_AIRBLGD 257-258

Form IRB_OBSND 259

Form IRB_OBSD_N_IMM 260

Form IRB_OBSD_IMM 261

Form IRB_ELEP 262 3. Section A gives the general instructions and definitions for the reporting of the IRB

return. Section B provides the specific instructions for calculating the risk-weighted amount for each IRB class/subclass under the IRB approach. Section C explains the calculation of total EL amount and total eligible provisions and the capital treatment for the difference between these two items under the IRB approach. Section D explains the specific reporting instructions for each reporting form, with illustrative examples provided in Annex IIIc-A.

4. This return and its completion instructions should be read in conjunction with the

Rules and the relevant supervisory policy/guidance on the revised capital adequacy framework.

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Section A: General Instructions I. Scope of the IRB Return 5. An AI is required to report in this return its credit exposures subject to the IRB

approach, including:

(a) all of the AI’s on-balance sheet exposures and off-balance sheet exposures booked in its banking book, except for exposures that are required to be deducted from any of the AI’s Common Equity Tier 1 capital (CET1 capital), Additional Tier 1 capital and Tier 2 capital 1 , exposures to a central counterparty (CCP) 2 and securitization exposures3;

(b) all of the AI’s exposures to counterparties –

(i) under over-the-counter derivative transactions (OTC derivative

transactions), credit derivative contracts or securities financing transactions (SFTs) booked in an AI’s trading book; or

(ii) in respect of assets that are –

posted by the AI as collateral for transactions or contracts booked in its

trading book; and held by the counterparties in a manner that is not bankruptcy remote

from the counterparties,

except for exposures that are subject to deduction from any of the AI’s CET1 capital, Additional Tier 1 capital and Tier 2 capital and exposures to a CCP.

6. Subject to the Monetary Authority’s (MA) prior consent, an AI using the IRB

approach may simultaneously have a portion of its credit exposures subject to the basic approach (BSC approach) and/or the standardized (credit risk) approach (STC approach), which should be reported in Form MA(BS)3(IIIa) and/or Form MA(BS)3(IIIb) according to the respective reporting requirements.

II. Classification of Exposures 7. In reporting this return, an AI should classify each of its credit exposures into one of

the six IRB classes and then sub-classify each of these exposures into one of the 1 Exposures that are required to be deducted from an AI’s CET1 capital, Additional Tier 1 capital and/or Tier 2 capital should be reported in Form MA(BS)3(II). 2 Exposures to CCPs should be reported in Form MA(BS)3(IIIe). 3 Securitization exposures include re-securitization exposures unless stated otherwise. Securitization exposures in the banking book should be reported in Form MA(BS)3(IIId), while securitization exposures in the trading book should be reported in Form MA(BS)3(IV).

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twenty six IRB subclasses as shown in the table below in accordance with the definitions given in paragraphs 13 to 33:

IRB Class IRB Subclass

1. Corporate exposures

(1) Specialized lending under supervisory slotting criteria approach (project finance)

(2) Specialized lending under supervisory slotting criteria approach (object finance)

(3) Specialized lending under supervisory slotting criteria approach (commodities finance)

(4) Specialized lending under supervisory slotting criteria approach (income-producing real estate)

(5) Specialized lending (high-volatility commercial real estate)

(6) Small-and-medium sized corporates

(7) Other corporates

2. Sovereign exposures

(8) Sovereigns

(9) Sovereign foreign public sector entities

(10) Multilateral development banks

3. Bank exposures

(11) Banks

(12) Securities firms

(13) Public sector entities (excluding sovereign foreign public sector entities)

4. Retail exposures

(14) Residential mortgages to individuals

(15) Residential mortgages to property-holding shell companies

(16) Qualifying revolving retail exposures

(17) Small business retail exposures

(18) Other retail exposures to individuals

5. Equity exposures

(19) Equity exposures under market-based approach (simple risk-weight method)

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IRB Class IRB Subclass

(20) Equity exposures under market-based approach (internal models method)

(21) Equity exposures under PD/LGD approach (publicly traded equity exposures held for long-term investment)

(22) Equity exposures under PD/LGD approach (privately owned equity exposures held for long-term investment)

(23) Equity exposures under PD/LGD approach (other publicly traded equity exposures)

(24) Equity exposures under PD/LGD approach (other equity exposures)

6. Other exposures

(25) Cash items

(26) Other items 8. Purchased receivables do not form an IRB class on their own and should be classified

as corporate exposures or retail exposures, as the case requires. III. Choice of IRB Calculation Approaches 9. Under the IRB approach, an AI may use the following IRB calculation approaches for

each of the six IRB classes, provided that the relevant criteria and qualifying conditions are met:

IRB class Corporate Sovereign Bank Retail Equity Other

App

roac

hes a

vaila

ble

foundation IRB approach

foundation IRB approach

foundation IRB approach

retail IRB approach

market-based approach: simple risk-weight method

specific risk-weight approach

advanced IRB approach

market-based approach: internal models method

advanced IRB approach

advanced IRB approach

supervisory slotting criteria approach

PD/LGD approach

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IV. Structure of the IRB Return 10. The IRB return consists of the following six divisions:

Division A: Summary of Risk-weighted Amount for Credit Risk under IRB Approach – showing the risk-weighted amount by IRB class/subclass and the effect of the scaling factor; a breakdown of the risk-weighted amount for selected types of exposures and the CVA risk-weighted amount4 for CVA risk is also shown;

Division B: Risk-weighted Amount by IRB Class/Subclass – providing information

on the credit risk components and risk-weighted amount of individual IRB subclasses or, where applicable, individual portfolio types;

Division C: LGD for Corporate, Sovereign and Bank Exposures – providing

supplementary information on LGD of individual IRB subclasses or, where applicable, individual portfolio types for corporate, sovereign and bank exposures under the foundation IRB approach or the advanced IRB approach;

Division D: Off-Balance Sheet Exposures (Other than OTC Derivative Transactions,

Credit Derivative Contracts and SFTs) under IRB Approach – providing supplementary information to Division B by giving a breakdown of off-balance sheet exposures (other than OTC derivative transactions, credit derivative contracts and SFTs) for corporate, sovereign, bank and retail exposures;

Division E: Off-Balance Sheet Exposures (OTC Derivative Transactions, Credit

Derivative Contracts and SFTs) under IRB Approach – providing supplementary information to Division B by giving a breakdown of OTC derivative transactions, credit derivative contracts and SFTs for corporate, sovereign, bank and retail exposures; and

Division F: EL-EP Calculation under IRB Approach – providing a breakdown of the

respective EL amount and eligible provisions for corporate, sovereign, bank and retail exposures and calculating the difference between the two, if any, for the computation of the capital base.

11. There are multiple forms in Divisions B, C and E of this return for the reporting of

different IRB subclasses of exposures or exposures subject to different calculation methods. A list showing the reporting forms under various divisions is given at Annex IIIc-B. For Divisions A, D and F, an AI is required to report the positions of all relevant IRB classes/subclasses in one single form. For Divisions B and C, the position of each IRB subclass (or, where applicable, each portfolio type) should be reported separately in the form applicable to that IRB subclass (or that portfolio type). For Division E, the positions should be reported separately according to the methods the AI adopts for the calculation of default risk exposures in respect of OTC

4 The term “CVA” in “CVA risk-weighted amount” refers to “credit valuation adjustment” – see definition in section 2(1) of the Rules. The CVA risk-weighted amount is the aggregate of such amounts reported in Form MA(BS)3(IIIf).

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derivative transactions, credit derivative contracts and SFTs. 12. Where an AI uses more than one internal rating system for an IRB class/subclass5, the

AI should split the exposures into portfolios according to the internal rating systems used and report each portfolio in one form under Division B (and, where applicable, Division C). In addition, the AI should provide a brief description of the nature of the portfolio under the item “portfolio type” of each separate form. An AI should consult with the HKMA on the appropriate reporting treatment if it has difficulties to report its exposures by portfolio in the above manner.

V. Definitions and Clarification (A) Definition of IRB Classes and Subclasses

Corporate Exposures 13. An AI should classify each of its exposures to corporates, including purchased

corporate receivables, into one of the following IRB subclasses:

(i) specialized lending (SL) under supervisory slotting criteria approach (project finance) (see paragraphs 14 to 16);

(ii) SL under supervisory slotting criteria approach (object finance) (see paragraphs

14 to 16);

(iii) SL under supervisory slotting criteria approach (commodities finance) (see paragraphs 14 to 16);

(iv) SL under supervisory slotting criteria approach (income-producing real estate)

(see paragraphs 14 to 16);

(v) Specialized lending (high-volatility commercial real estate) (see paragraphs 14 to 16);

(vi) small-and-medium sized corporates (SME corporates) (see paragraph 17); and

(vii) other corporates (see paragraph 18).

(a) SL 14. SL is a corporate exposure that possesses, unless specified otherwise, all of the

following characteristics, either in legal form or economic substance: 5 For example, an AI may have more than one internal rating system for its qualifying revolving retail exposures, such as having separate scorecards for credit card lending and personal revolving loans.

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(i) the exposure is usually to a corporate (often a special purpose vehicle (SPV)) which has been created specifically to own and/or operate a specific asset (in other words, it has little or no other material assets or activities);

(ii) the terms of the exposure give the AI (i.e. the lender) a substantial degree of

control over the specific asset and the income which the specific asset generates; and

(iii) the primary source of repayment of the exposure is the income generated by the

specific asset (i.e. rather than other sources of income generated by the corporate).

15. There are five types of SL:-

(i) Project finance (PF): PF refers to a method of funding in which an AI looks primarily to the revenue generated by a single project, both as the source of repayment of, and as collateral for, the exposure. PF is usually for large, complex and expensive installations that may include, for example, power plants, chemical processing plants, mines, transportation infrastructure, and telecommunications infrastructure. It may take the form of financing of the construction of a new capital installation, or refinancing of an existing installation, with or without improvements. The borrowing entity is usually an SPV established for the purpose of the project that is not permitted to perform any function other than developing, owning and operating the installation. The consequence is that repayment depends primarily on the project’s cash flows (such as electricity sold by a power plant) and on the collateral value of the project’s assets. In contrast, if repayment of the exposure depends primarily on a well established, diversified, credit-worthy and contractually obligated entity, the exposure should be treated as a collateralized exposure to that entity;

(ii) Object finance (OF): OF refers to a method of funding the acquisition of

physical assets (e.g. taxis, public light buses, ships, aircraft and satellites) where the repayment of the exposure is dependent on the cash flows generated by the assets that have been financed and pledged or assigned to an AI. A primary source of these cash flows may be rental or lease contracts with one or several third parties. In contrast, if the exposure is to a borrowing entity whose financial condition and debt-servicing capacity enables it to repay the debt without undue reliance on the specifically pledged assets, the exposure should be treated as a collateralized corporate exposure;

(iii) Commodities finance (CF): CF refers to a structured short-term lending to

finance reserves, inventories, or receivables of exchange-traded commodities (e.g. metals, energy or agricultural products), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrowing entity has no other sources of income to repay the exposure. This is the case when the borrowing entity has no other activities and no other material assets on its balance sheet. The structured nature of the financing is designed to compensate for the weak credit quality of the borrowing entity. The rating of the exposure reflects its self-liquidating nature and the AI’s skill in structuring the transaction rather than the credit quality of the borrowing entity. Such lending can be

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distinguished from exposures financing the reserves, inventories, or receivables of other more diversified borrowing entities where the AI is able to rate the credit quality of these latter entities based on their broader ongoing operations. In such cases, the value of the commodity serves as a risk mitigant rather than as the primary source of repayment;

(iv) Income-producing real estate (IPRE): IPRE refers to a method of funding to

finance real estate (such as office buildings, retail shops, residential buildings, industrial or warehouse premises, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The borrowing entity may be, but is not required to be, an SPV, an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralized by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property; and

(v) High-volatility commercial real estate (HVCRE): HVCRE is the financing of

commercial real estate that exhibits a higher loss rate volatility (i.e. higher asset correlation) compared to other types of SL. HVCRE exposures include:

Commercial real estate exposures secured by any commercial real estate of a type that is categorized and announced by the MA or a relevant banking supervisory authority outside Hong Kong as sharing a higher volatility in portfolio default rate;

Commercial real estate exposures financing any of the land acquisition,

development and construction phases (ADC phases) of commercial real estate of a type referred to above; and

Exposures financing the ADC phases of any other commercial real estate

where the source of repayment at origination of the exposure is either the future uncertain sale of the commercial real estate or cash flows whose source of repayment is substantially uncertain (e.g. the commercial real estate has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), and the borrowing entity in respect of the exposure does not have substantial equity at risk in the commercial real estate. Specified ADC exposures as defined under section 158(6) of the Rules, however, are ineligible for the preferential treatment set out in section 158(3) of the Rules.

Pursuant to section 143(4A) and (5)(ba) of the Rules, and unlike other types of SL, an AI’s corporate exposures that meet the descriptions of HVCRE exposures above must be categorized into the IRB subclass of specialized lending (high-volatility commercial real estate) and are precluded from falling within any other IRB subclasses of corporate exposures (such as the IRB subclass of specialized lending (income-producing real estate)).

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16. An AI that does not meet the requirements for PD estimation under the foundation IRB approach, or those for the estimation of PD, LGD and EAD and the calculation of M under the advanced IRB approach, for its SL should use the supervisory slotting criteria approach to derive the risk-weighted amount of such SL, by:

(i) assigning the SL to internal grades based on its own rating criteria and map its

internal grades to the five supervisory rating grades of “strong”, “good”, “satisfactory”, “weak” and “default” (see paragraph 75) by reference to the criteria specified in Annex 6 to the document entitled “International Convergence of Capital Measurement and Capital Standards – A Revised Framework (Comprehensive Version)” published by the Basel Committee on Banking Supervision in June 2006 or the credit quality grades specified in Schedule 8 of the Rules; and

(ii) complying with applicable requirements set out in section 158(2) of the Rules.

(b) SME corporates 17. In respect of an exposure to a corporate (other than HVCRE exposures) which has a

reported total annual revenue (or a consolidated reported total annual revenue for the group of which the corporate is a part6) of less than HK$500 million, an AI may classify the exposure under the IRB subclass of SME corporates. In the case where total annual revenue is not a meaningful indicator of the scale of business of a corporate, the MA may, on an exceptional basis, allow an AI to substitute the total assets for total annual revenue in applying the above threshold for that corporate. To ensure that the information used is timely and accurate, the AI should obtain the total annual revenue figures from the corporate’s latest audited financial statements7 and have the figures updated at least annually.

(c) Other corporates 18. An AI should classify all of its exposures to corporates which do not fall within any of

the following IRB subclasses:

(i) SL under supervisory slotting criteria approach (PF);

(ii) SL under supervisory slotting criteria approach (OF);

(iii) SL under supervisory slotting criteria approach (CF);

6 Where the corporate concerned is consolidated with other corporates by the AI for risk management purposes, the figure of the consolidated reported total annual revenue can be derived from the aggregate of the reported total annual revenue in the latest annual financial statements of the corporate concerned and the other corporates. 7 This does not apply to those customers that are not subject to statutory audit (such as a sole proprietorship). In such cases, an AI should obtain their latest available management accounts.

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(iv) SL under supervisory slotting criteria approach (IPRE); (v) SL (high-volatility commercial real estate);

(vi) SME corporates;

(vii) residential mortgages (RM) to property-holding shell companies (see paragraph

25); and

(viii) small business retail exposures (see paragraph 27),

as exposures under the IRB subclass of other corporates.

Sovereign Exposures 19. Sovereign exposures8 include exposures which fall within one of the following IRB

subclasses:

(i) sovereigns;

(ii) sovereign foreign public sector entities (SFPSEs); and

(iii) multilateral development banks (MDBs).

Bank Exposures 20. Bank exposures include exposures which fall within one of the following IRB

subclasses:

(i) banks;

(ii) securities firms; and

(iii) public sector entities (PSEs) that are not SFPSEs.

Retail Exposures 21. Exposures to individuals which, regardless of exposure size, are managed by an AI on

a pooled or portfolio basis9 should be classified as retail exposures. Retail exposures to individuals usually include residential mortgage loans (RMLs), revolving credits (e.g. credit cards and overdrafts) and other personal loans (e.g. instalment loans, auto

8 Holdings of notes and coins should be reported as cash items under the IRB class of other exposures (see paragraph 33). 9 The MA does not intend to set the minimum number of retail exposures in a portfolio. An AI should establish its own policies to ensure the granularity and homogeneity of its retail exposures.

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loans, tax loans, personal finance and other retail credits with similar characteristics). For those exposures which are not managed by an AI on a pooled or portfolio basis10, an AI should treat them as corporate exposures.

22. Exposures to corporates may also be classified as retail exposures, provided that the

criteria set out in paragraph 27 are met. 23. An AI should classify each of its retail exposures, including purchased retail

receivables, into one of the following IRB subclasses:

(i) RM to individuals (see paragraph 24);

(ii) RM to property-holding shell companies (see paragraph 25);

(iii) qualifying revolving retail exposures (QRRE) (see paragraph 26);

(iv) small business retail exposures (see paragraph 27); and

(v) other retail exposures to individuals (see paragraph 28).

(a) RM to individuals 24. RM to individuals refers to RMLs (including first and subsequent liens, term loans

and revolving home equity lines of credit) that are extended to individuals, regardless of exposure size, and that the property secured for the loan is used, or intended for use, as the residence of the borrower or as the residence of a tenant, or a licensee, of the borrower.

(b) RM to property-holding shell companies 25. RM to property-holding shell companies refers to RMLs granted to property-holding

shell companies on the condition that the credit risk of such loans is akin to those granted to individuals. This is considered to be the case where:

(i) the property securing the RML is used, or intended for use, as the residence of

one or more than one director or shareholder of the property-holding shell company or as the residence of a tenant, or a licensee, of the property-holding shell company;

(ii) the RML granted to the property-holding shell company is fully and effectively

covered by a personal guarantee entered into by one or more than one director or shareholder of the company (“the guarantors”);

10 This does not preclude retail exposures from being treated individually at some stages of the risk management process. The fact that an exposure is rated individually does not by itself preclude it from being eligible as a retail exposure.

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(iii) the AI is satisfied that the above guarantors are able to discharge their financial obligations under the guarantees, having due regard to their overall indebtedness; and

(iv) the RML granted to the property-holding shell company has been assessed by

reference to substantially similar credit underwriting standards (e.g. the loan purpose, loan-to-value ratio and debt-service ratio) as would normally be applied by the AI to an individual.

(c) QRRE 26. An AI should classify under the IRB subclass of QRRE a retail exposure that meets

the following criteria:

(i) the exposure is revolving, unsecured, and unconditionally cancellable (both contractually and in practice) by the AI;

(ii) the exposure is to one or more than one individual and not explicitly for

business purposes;

(iii) the exposure is not more than HK$1 million;

(iv) the exposure belongs to a pool of exposures which have exhibited, in comparison with other IRB subclasses of retail exposures, low loss rate volatility relative to the AI’s average level of loss rates for retail exposures, especially within the pools to which low estimates of PD are attributed11;

(v) data on loss rates for the QRRE portfolio(s) are retained by the AI in order to

allow analysis of the volatility of loss rates; and

(vi) treatment of the exposure as QRRE is consistent with the underlying risk characteristics of the exposure.

(d) Small business retail exposures 27. An AI may classify its exposures to a corporate under the IRB subclass of small

business retail exposures, provided that:

(i) the total exposure of the AI or, where applicable, of its consolidation group to the corporate (or, where applicable, to the consolidated group of which the corporate is a part) is less than HK$10 million12;

11 This is because the correlation value (R) of the QRRE risk-weight formula is markedly below that of the risk-weight formula for other IRB subclasses of retail exposures, especially at low PD values. 12 Small business credits extended through, or guaranteed by, an individual are subject to the same exposure threshold.

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(ii) the exposures are originated by the AI in a manner similar to retail exposures to individuals; and

(iii) the exposures are managed by the AI on a pooled or portfolio basis in the same

manner as retail exposures to individuals. In other words, they should not be managed individually in a way similar to corporate exposures, but rather as a portfolio segment or a pool of exposures with similar risk characteristics for the purposes of risk assessment and quantification.

(e) Other retail exposures to individuals 28. Other retail exposures to individuals include all retail exposures to individuals (see

paragraph 21) which do not fall within the IRB subclass of:

(i) RM to individuals (see paragraph 24); or

(ii) QRRE (see paragraph 26).

Equity Exposures 29. An AI should consider the economic substance of an instrument in determining

whether the instrument should be classified as an equity exposure. Equity exposures include both direct and indirect ownership interests (whether voting or non-voting) in a corporate13 where those interests are not consolidated or deducted for the purposes of calculating an AI’s capital base. These instruments include:

(i) holdings of any share issued by a corporate;

(ii) holdings of any equity contract;

(iii) holdings in any collective investment scheme which is engaged principally in

the business of investing in equity interests;

(iv) holdings of any instrument which would be included in an AI’s CET1 capital or Additional Tier 1 capital if the instrument were issued by the AI;

(v) holdings of any instrument:

• which is irredeemable in the sense that the return of the invested funds can

be achieved only by the sale of the instrument or the sale of the rights to the instrument or by the liquidation of the issuer;

• which does not embody an obligation on the part of the issuer (subject to item (vi)); and

• which conveys a residual claim on the assets or income of the issuer;

13 For the purposes of categorizing exposures into the IRB class of equity exposures, corporate means a company, or a partnership or any other unincorporated body, that is not a public sector entity.

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(vi) holdings of any instrument which embodies an obligation on the part of the

issuer and in respect of which:

• the issuer may indefinitely defer the settlement of the obligation;

• the obligation requires (or permits at the issuer’s discretion) settlement by the issuance of a fixed number of the issuer’s equity shares;

• the obligation requires (or permits at the issuer’s discretion) settlement by the issuance of a variable number of the issuer’s equity shares and, other things being equal, any change in the value of the obligation is attributable to, comparable to, and in the same direction as, the change in the value of a fixed number of the issuer’s equity shares14; or

• the AI, as the holder of the instrument, has the option to require that the obligation be settled in equity shares, unless the AI demonstrates to the satisfaction of the MA that: (a) in the case of a traded instrument, the instrument trades more like debt of the issuer than equity; or (b) in the case of a non-traded instrument, the instrument should be treated as a debt holding;

(vii) holdings of any debt obligation, share, derivative contract, investment scheme

or instrument, which is structured with the intent of conveying the economic substance of equity interests15; and

(viii) any of the AI’s liabilities on which the return is linked to that of equity interests.

30. An AI should not classify as equity exposures any equity holding which is structured

with the intent of conveying the economic substance of debt holdings or securitization exposures. The MA may, on a case-by-case basis, require an AI to re-classify a debt holding as an equity exposure if the MA considers that the nature and economic substance of the debt holding are more akin to an equity exposure than a debt holding.

31. An AI adopting the IRB approach is required to classify each of its equity exposures

booked in the banking book under one of the following IRB subclasses based on the method in use (i.e. the market-based approach or the PD/LGD approach) and, where applicable, the portfolio types:

(i) equity exposures under market-based approach (simple risk-weight method);

14 For certain obligations that require or permit settlement by the issuance of a variable number of the issuer’s equity shares, the change in the monetary value of the obligation is equal to the change in the fair value of a fixed number of equity shares multiplied by a specified factor. Those obligations meet the conditions of this item if both the factor and the reference number of shares are fixed. For example, an issuer may be required to settle an obligation by issuing shares with a value equal to three times the appreciation in the fair value of 1,000 equity shares. That obligation is considered to be the same as an obligation that requires settlement by the issuance of shares equal to the appreciation in the fair value of 3,000 equity shares. 15 Equity interests that are recorded by an AI as a loan, but which arise from a debt/equity swap made as part of the orderly realization or restructuring of a debt should be classified as equity exposures. However, these exposures may not be allocated a lower risk-weight than would apply if such holdings had remained in the AI’s debt portfolio.

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(ii) equity exposures under market-based approach (internal models method);

(iii) equity exposures under PD/LGD approach (publicly traded equity exposures

held for long-term investment);

(iv) equity exposures under PD/LGD approach (privately owned equity exposures held for long-term investment);

(v) equity exposures under PD/LGD approach (other publicly traded equity

exposures); and

(vi) equity exposures under PD/LGD approach (other equity exposures). 32. Equity exposures booked in the trading book are not subject to the IRB approach.

Instead, these exposures should be subject to the market risk capital treatment and reported in Form MA(BS)3(IV).

Other Exposures 33. An AI should classify under the IRB class of other exposures any of its exposures

which do not fall within the IRB class of corporate, sovereign, bank, retail or equity exposures. These exposures include:

(i) cash items, the types of exposures covered are set out in the table under

paragraph 134; and

(ii) other items, which are other exposures that do not fall within the IRB subclass of cash items, e.g. premises, plant and equipment and other fixed assets for own use (see paragraph 135).

(B) Clarification 34. Figures of percentage or year should be rounded up to two decimal points. 35. An AI should report in the columns of “Exposures before recognized guarantees /

credit derivative contracts” the EAD of its on-balance sheet exposures and off-balance sheet exposures before adjusting for the credit risk mitigating effects of any recognized guarantee and recognized credit derivative contract. For instance:

(i) in respect of on-balance sheet exposures, the AI should report the EAD of such

exposures both before and after adjusting for the credit risk mitigating effects of any recognized netting;

(ii) in respect of off-balance sheet exposures (Other than OTC derivative

transactions, credit derivative contracts and SFTs), the AI should report the credit equivalent amount of such exposures; and

(iii) in respect of off-balance sheet exposures (OTC derivative transactions, credit

MA(BS)3(IIIc) /P.17 (03/2016)

derivative contracts and SFTs), the AI should report the default risk exposures of such transactions after adjusting for the credit risk mitigating effects of any recognized netting.

36. An AI should report in the columns of “Exposures after recognized guarantees / credit

derivative contracts” the EAD of its on-balance sheet exposures and off-balance sheet exposures after adjusting for the credit risk mitigating effects of any recognized netting, recognized guarantee and recognized credit derivative contract.

37. Principal amount, in respect of an off-balance sheet exposure, should be

reported without deduction of specific provisions and partial write-offs. 38. Double counting of exposures arising from the same contract or transaction should be

avoided. For example, only the undrawn portion of a corporate loan commitment should be reported as an off-balance sheet exposure in item 9 or 10 of Form IRB_OBSND and columns (7) and (10) of Form IRB_CSB while the actual amount drawn should be reported as an on-balance sheet exposure in columns (6) and (9) of Form IRB_CSB. Similarly, trade-related contingencies, e.g. trust receipts and shipping guarantees for which the exposures have already been reported as letters of credit issued or loans against import bills etc., should not be reported under item 3 of Form IRB_OBSND and columns (7) and (10) of Form IRB_CSB.

39. In certain cases, credit exposures arising from OTC derivative transactions may have

already been fully or partially reflected on the balance sheet. For example, an AI may have already recorded the current exposures to counterparties (i.e. mark-to-market values) under foreign exchange and interest rate related contracts on the balance sheet, typically as either sundry debtors or sundry creditors. To avoid double counting, such exposures should be excluded from on-balance sheet exposures and reported under the OTC derivative transactions for the purposes of this return.

40. The accrued interest of a credit exposure should form part of the EAD of the credit

exposure. An AI should therefore classify and risk-weight the accrued interest receivables in the same way as the principal amount of the respective credit exposures.

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Section B: Calculation of Risk-weighted Amount for Credit Risk under IRB Approach I. Risk-weighted Amount under IRB Approach 41. The IRB approach to credit risk is based on measures of unexpected loss (UL) and

expected loss (EL). The risk-weight functions in this section produce capital requirements for the UL portion. EL is treated separately as outlined in section C.

42. An AI should calculate the risk-weighted amount for the UL of its credit exposures

(excluding exposures that are subject to deduction from the AI’s CET1 capital, Additional Tier 1 capital and Tier 2 capital, securitization exposures and exposures to CCPs) under the IRB approach as follows:

(i) the AI should calculate the risk-weighted amount of each exposure (except

equity exposures to which item (ii) applies and counterparty credit risk exposures to which item (iii) applies) by multiplying the EAD of each such exposure by the relevant risk-weight;

(ii) in respect of an equity exposure which is subject to the internal models method

and for which the relevant minimum risk-weight (see paragraph 121(ii)) does not apply, the AI should calculate the risk-weighted amount by multiplying the potential loss of the exposure calculated under the internal models method by 12.5;

(iii) in respect of OTC derivative transactions, credit derivative contracts or SFTs,

the AI must calculate the risk-weighted amount of the counterparty credit risk exposure -

(a) if the AI has an IMM(CCR) approval16 and an approval to use the IMM

approach17 to calculate the market risk capital charge for specific risk for interest rate exposures, by aggregating -

the IMM(CCR) risk-weighted amount of the transactions or contracts concerned that are covered by the IMM(CCR) approval;

the CEM risk-weighted amount18 or SFT risk-weighted amount19 of the transactions or contracts concerned that are (i) not covered by the IMM(CCR) approval; or (ii) covered by the IMM(CCR) approval but fall within section 10B(5) or (7) of the Rules; and

16 The term “IMM(CCR)” in “IMM(CCR) approval” refers to the internal models (counterparty credit risk) approach (IMM(CCR) approach) - see definitions in section 2(1) of the Rules. 17 The term “IMM approach” refers to the internal models approach for the calculation of market risk - see definition in section 2(1) of the Rules. 18 The term “CEM” in “CEM risk-weighted amount” refers to the current exposure method - see definition in section 2(1) of the Rules. 19 See the definition of “SFT risk-weighted amount” in section 139(1) of the Rules.

MA(BS)3(IIIc) /P.19 (03/2016)

the CVA risk-weighted amount determined using the advanced CVA method (and reported in Division A of Form MA(BS)3(IIIf)), the standardized CVA method (and reported in Division B of Form MA(BS)3(IIIf)), or a combination of those 2 methods that is permitted under the Rules, as the case requires;

(b) if the AI has an IMM(CCR) approval but does not have an approval to use the IMM approach to calculate the market risk capital charge for specific risk for interest rate exposures, by aggregating -

the IMM(CCR) risk-weighted amount of the transactions or contracts concerned that are covered by the IMM(CCR) approval;

the CEM risk-weighted amount or SFT risk-weighted amount of the transactions or contracts concerned that are (i) not covered by the IMM(CCR) approval; or (ii) covered by the IMM(CCR) approval but fall within section 10B(5) or (7) of the Rules; and

the CVA risk-weighted amount determined using the standardized CVA method (and reported in Division B of Form MA(BS)3(IIIf)); and

(c) if the AI does not have an IMM(CCR) approval for any of its transactions or contracts, by aggregating -

the CEM risk-weighted amount;

the SFT risk-weighted amount; and

the CVA risk-weighted amount determined using the standardized CVA method (and reported in Division B of Form MA(BS)3(IIIf)); and

(iv) the AI should aggregate the risk-weighted amount figures derived from items (i), (ii) and (iii) (except the CVA risk-weighted amounts reported in Form MA(BS)3(IIIf)) and then apply a scaling factor20 (1.06) to the aggregate figure to arrive at the total risk-weighted amount for credit risk under the IRB approach.

43. For the purposes of paragraph 42(iii), an AI may, in the case of a default risk exposure

in respect of long settlement transactions (LSTs), determine the exposure’s relevant risk-weight using the STC approach on a permanent basis.

44. An AI must regard the total amount of the CVA capital charge for its counterparties

determined in accordance with Division 3 of Part 6A of the Rules as the basis for determining the CVA risk-weighted amount of the AI as required under paragraph 42(iii), regardless of whether any of those counterparties falls within Part 6 of the Rules. That means the CVA risk-weighted amounts reported in Form MA(BS)3(IIIf)

20 The scaling factor also applies to securitization exposures under the IRB(S) approach (see Form MA(BS)3(IIId)).

MA(BS)3(IIIc) /P.20 (03/2016)

should be aggregated and reported in item 9 of Division A of Form MA(BS)3(IIIc). 45. An AI may reduce the risk-weighted amount of an exposure by taking into account

the effect of any recognized credit risk mitigation through adjusting the PD, LGD or EAD, as the case may be, in accordance with Part XIII of this section.

II. General Requirements for All IRB Classes (A) General Requirements 46. There are three key elements for calculation of risk-weighted amount for the UL

portion under the IRB approach, including:

(i) credit risk components – these are estimates of PD, LGD, EAD, EL and M made by an AI, or supervisory estimates specified in the Rules;

(ii) risk-weight functions – these are the formulae by which credit risk components

are transformed into risk-weighted amount and therefore capital requirements; and

(iii) minimum requirements - the minimum standards which an AI should meet for

the use of the IRB approach21. 47. An AI should use the risk-weight functions provided in this section for the purpose of

calculating the risk-weighted amount, unless otherwise specified. In applying such risk-weight functions, PD and LGD are measured as decimals, EAD is measured in HK$ and M is measured in years.

48. For the purposes of calculating the EAD of an exposure (whether held on- or off-

balance sheet) that is measured at fair value, an AI should comply with the prudent valuation and valuation adjustment requirements in section 4A of the Rules.

(B) Corporate, Sovereign and Bank Exposures 49. Under the foundation IRB approach, an AI should provide its own estimates of PD

associated with each of its obligor grades, but should use supervisory estimates for other credit risk components (i.e. LGD, EAD and M22).

50. Under the advanced IRB approach, an AI should provide its own estimates of PD,

LGD and EAD and calculate M.

21 Please refer to Part 6 and Schedule 2 of the Rules and the relevant supervisory policy/guidance relating to the IRB approach. 22 The use of explicit maturity adjustments is not required under the foundation IRB approach. Subject to the MA’s prior consent, an AI having suitable systems for the calculation of M may be allowed to use explicit maturity adjustments under the foundation IRB approach.

MA(BS)3(IIIc) /P.21 (03/2016)

51. In respect of SL under supervisory slotting criteria approach (see paragraph 16), an AI should apply the supervisory estimate of a risk-weight that is applicable to a supervisory rating grade (see paragraph 75) in calculating the risk-weighted amount of such SL.

(C) Retail Exposures 52. Under the retail IRB approach, an AI should provide its own estimates of PD, LGD

and EAD associated with each pool of retail exposures. There is no distinction between a foundation approach and an advanced approach for retail exposures.

(D) Equity Exposures 53. There are two approaches to calculating the risk-weighted amount of equity exposures

held in the banking book: (i) the market-based approach and (ii) the PD/LGD approach23. Under the market-based approach, an AI may use the simple risk-weight method, the internal models method or a combination of both. However, for certain types of equity exposures that meet specified descriptions, a supervisory risk-weight applies to the relevant exposures irrespective of the calculation approaches the exposures are subject to (see paragraphs 119 and 120).

(E) Other Exposures 54. Under the specific risk-weight approach, an AI should apply a specific risk-weight

applicable to an exposure which falls within the IRB subclass of cash items (see paragraph 134) or the IRB subclass of other items (see paragraph 135) in calculating the risk-weighted amount of the exposure.

III. Specific Requirements for Certain Exposure Portfolios (A) Purchased Receivables 55. Purchased receivables straddles corporate and retail IRB classes. For purchased

corporate receivables, both the foundation IRB approach and the advanced IRB approach are available subject to the relevant minimum requirements being met. Like other retail exposures, there is no distinction between a foundation approach and an advanced approach for purchased retail receivables. For purchased receivables (whether corporate or retail), an AI is required to calculate the risk-weighted amount for default risk and, if material, dilution risk of such purchased receivables (see Part VIII of this section).

23 The PD/LGD approach to equity exposures remains available for an AI adopting the advanced IRB approach for its corporate, sovereign and bank exposures.

MA(BS)3(IIIc) /P.22 (03/2016)

(B) Leasing Transactions 56. There is a distinct treatment for calculating the risk-weighted amount of exposures

arising from leases with residual value risk (see Part IX of this section). Leases without any residual value risk will be accorded the same treatment as exposures collateralized by the underlying leased assets.

(C) Securities Financing Transactions (SFTs) 57. The calculation of the risk-weighted amount for SFTs depends on the economic

substance of the transaction and whether the transaction is booked in the banking book or the trading book (see Part X of this section).

(D) Credit-linked Notes 58. The calculation of the risk-weighted amount for a credit-linked note depends on the

risk-weight attributable to the reference obligation or basket of reference obligations of the note, the note issuer, and the AI’s maximum liability under the note (see Part XI of this section).

IV. Corporate, Sovereign and Bank Exposures (A) Risk-weight Function for Derivation of Risk-weighted Amount 59. The calculation of the risk-weighted amount of a corporate, sovereign or bank

exposure is dependent on the estimates of PD, LGD, EAD and, in some cases, M, of a given exposure.

(a) Non-defaulted exposures

60. Subject to paragraph 77, for corporate, sovereign and bank exposures that are not in

default (but excluding those treated as hedged exposures under the double default framework), the risk-weighted amount is calculated as follows 24, 25:

Correlation (R)

= 0.12 × (1 - EXP (-50 × PD)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PD)) / (1 - EXP (-50))]

24 EXP denotes exponential and ln denotes the natural logarithm. 25 N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z). The normal cumulative distribution function and the inverse of the normal cumulative distribution function are, for example, available in Excel as the functions NORMSDIST and NORMSINV.

MA(BS)3(IIIc) /P.23 (03/2016)

Maturity adjustment (b) = (0.11852 - 0.05478 × ln (PD))^2

Capital charge factor26 (K)

= [LGD × N [(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] - PD x LGD] x (1 - 1.5 x b)^ -1 × (1 + (M - 2.5) × b)

Risk-weight (RW) = K x 12.5

Risk-weighted amount = RW x EAD

(Illustrative risk-weights are shown in Annex IIIc-C.)

(b) Defaulted exposures 61. An AI should use the same risk-weight function set out in paragraph 60 to calculate

the risk-weighted amount of its corporate, sovereign and bank exposures which are in default (i.e. a default of the obligor in respect of the exposure has occurred by virtue of section 149(1) or (5A) of the Rules), except that the capital charge factor (K) for a defaulted corporate, sovereign or bank exposure should be equal to the greater of:

(i) zero; or (ii) the figure resulting from the subtraction of the AI’s best estimate of the EL27

from the LGD of the defaulted exposure.

(c) Hedged exposures under double default framework 62. For any hedged exposure under the double default framework (see paragraphs 219 and

220), the risk-weighted amount is calculated as below:

Correlation (ρos)

= 0.12 × (1 - EXP (-50 × PDo)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PDo)) / (1 - EXP (-50))]

Maturity adjustment (bos) = (0.11852 - 0.05478 × ln (PDos))^2

26 If this calculation results in a negative capital charge for any individual sovereign exposure, an AI should apply a zero capital charge for that exposure. 27 With the prior consent of the MA, an AI which uses the foundation IRB approach may use the supervisory estimate for the LGD as the EL for its corporate, sovereign and bank exposures which are in default.

MA(BS)3(IIIc) /P.24 (03/2016)

Capital charge factor (KDD)

)PD160(0.15b1.51

b2.5)(M1PD

1

G(0.999))G(PD NLGD g

os

ososo

os

soog ×+×

×−×−+

×

−

−

×+×=

ρ

ρ

Risk-weight (RWDD) = KDD x 12.5

Risk-weighted amount = RWDD x EADg

where:

PDo = PD of the underlying obligor without taking into account the effect of credit protection (see paragraph 80)

PDg = PD of the credit protection provider of the hedged exposure (see paragraph 80)

PDos = The lower of PDo and PDg Mos = M of the credit protection (see paragraph 107)

LGDg = LGD of a comparable direct exposure to the credit protection provider (see paragraphs 98 and 99)

EADg = EAD of the hedged exposure

63. Defaulted exposures cannot be subject to the double default framework. In case the

underlying obligor of a hedged exposure defaults, such exposure should be treated as a direct exposure to the credit protection provider and then risk-weighted accordingly. Conversely, if the credit protection provider of a hedged exposure defaults, such exposure should remain with the underlying obligor and should be risk-weighted as an unhedged exposure to the underlying obligor. In case both the underlying obligor and the credit protection provider of a hedged exposure default, such exposure should be treated as a defaulted exposure to either the underlying obligor or the credit protection provider, depending on which party defaulted last.

(d) OTC derivative transactions and credit derivative contracts - Full maturity adjustment

64. Where an AI that uses the advanced CVA method to calculate its CVA capital charge

demonstrates to the satisfaction of the MA that its VaR model used in the advanced CVA method adequately covers the effects of rating migrations, the institution may— (i) calculate the risk-weight applicable to a default risk exposure in respect of OTC

derivative transactions or credit derivative contracts under paragraph 60 with the full maturity adjustment set equal to 1; and

(ii) calculate the risk-weight applicable to a default risk exposure in respect of OTC

derivative transactions or credit derivative contracts under paragraph 62 with the full maturity adjustment set equal to 1 but the credit protection provider must be one of the counterparties covered by the CVA capital charge calculation.

MA(BS)3(IIIc) /P.25 (03/2016)

65. The term “full maturity adjustment” in paragraph 64(i) and (ii) means -

(i) that amount calculated by the component (1 – 1.5 × b)^ – 1 × (1 + (M – 2.5) × b) in Formula 16 of the Rules (see paragraph 60); or

(ii) that amount calculated by the component ( )

os

osos

bbM

×−×−+

5.115.21

in Formula 17 of the Rules (see paragraph 62),

as the case requires.

(e) SME corporates - Firm-size adjustment 66. An AI using the IRB approach is permitted to separately distinguish its corporate

exposures as SME corporates as defined in paragraph 17. For these SME corporate exposures, a firm-size adjustment (i.e. 0.04 x (1 - (S-50) / 450)) must be applied to the relevant risk-weight function as set out in paragraph 60 or 62, as the case requires, for the calculation of the correlation value:

(i) Exposures to SME corporates that are not subject to the double default

framework

Correlation (R)

= 0.12 × (1 - EXP (-50 × PD)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PD)) / (1 - EXP (-50))] - 0.04 × (1 - (S - 50) / 450)

(ii) Exposures to SME corporates that are subject to the double default framework

Correlation (pos)

= 0.12 × (1 - EXP (-50 × PDo)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PDo)) / (1 - EXP (-50))] - 0.04 × (1 - (S - 50) / 450)

where S is expressed as the total annual revenue of the SME corporate (or the consolidated total annual revenue of the group of which the SME corporate is a member28) in millions of HK$ with the value of S falling in the range from HK$50 million to HK$500 million. Total annual revenue of less than HK$50 million will be deemed as equivalent to HK$50 million for the purpose of the firm-size adjustment. In the case where total annual revenue does not accurately reflect a corporate’s scale of business, the MA may, on an exceptional basis, allow an AI to substitute the corporate’s total assets for the total annual revenue in calculating the firm-size adjustment for the SME corporate.

28 An AI should treat a SME corporate and other corporates which are consolidated by the AI for risk management purposes as a consolidated group.

MA(BS)3(IIIc) /P.26 (03/2016)

(f) Exposures to certain financial institutions – Correlation adjustment by way of asset value correlation multiplier

67. For an AI’s corporate, sovereign or bank exposure to an obligor that is (i) a large

regulated financial institution; or (ii) a financial institution that is not supervised by a financial regulator, the AI must multiply the correlation (R) or correlation (ρos) in the risk weight function set out in paragraph 60 or 62, as the case requires, by 1.25.

68. For the purposes of paragraph 67,

“financial institution” means an entity that-

(a) is a financial sector entity; or (b) is engaged predominantly in any one or more of the following activities,

whether by itself or through any of its subsidiaries—

(i) lending; (ii) factoring; (iii) provision of credit enhancement; (iv) securitization; (v) proprietary trading; (vi) any other financial services activity specified in Part 11 of Schedule

1 of the Rules;

“financial regulator” means a regulatory authority that imposes supervisory standards (including supervisory standards relating to capital and liquidity) that are substantially consistent with international standards;

“large regulated financial institution” means a financial institution that is

supervised by a financial regulator and that—

(a) has total assets of not less than HK$780 billion as determined by reference to the institution’s most recent audited consolidated financial statements or (if the institution does not have any subsidiary) the institution’s most recent audited financial statements; or

(b) is a member of a group of companies (comprised of the ultimate holding

company29 and all of its subsidiaries) that has total assets of not less than HK$780 billion as determined by reference to the group’s most recent audited consolidated financial statements.

69. To ensure that the information used for determining whether a financial institution is a

29 There could be many forms and levels of consolidation in respect of a group of companies. To avoid any arbitrary specification, the HKMA intends to leverage on the consolidation requirements prescribed by generally acceptable accounting standards applicable to the financial groups. For the purposes of determining the total assets of the wider group of a financial institution under the definition of “large regulated financial institution”, the top-most holding company included in the highest level of audited consolidated financial statements of a financial group (which comprises an ultimate holding company and all of its subsidiaries) should be regarded as the “ultimate holding company”.

MA(BS)3(IIIc) /P.27 (03/2016)

large regulated financial institution is timely and accurate, the AI should obtain the total assets figures from the latest audited financial statements of the financial institution or its wider group, as the case requires, and have the figures updated at least annually.

70. For the avoidance of doubt, if a SME corporate that is subject to the firm-size

adjustment mentioned in paragraph 66 is also a financial institution to which the asset value correlation multiplier requirements mentioned in paragraph 67 apply, an AI should apply the adjustments mentioned in both paragraphs to the correlation (R) or correlation (ρos) in the risk-weight function set out in paragraph 60 or 62, as the case requires.

(g) SL 71. The capital treatments set out in this subsection apply to all types of SL (see

paragraph 15) unless otherwise specified. 72. An AI that meets the requirements for PD estimation under the IRB approach for its

SL should use the foundation IRB approach (or the advanced IRB approach, where the AI can also provide the estimates of other credit risk components) to calculate the risk-weighted amount for such SL, based on the relevant risk-weight functions set out in paragraphs 59 to 70.

73. The use of the foundation IRB approach or the advanced IRB approach by an AI in

respect of its HVCRE exposures is subject to the additional requirements set out in section 158(1A), (1B) and (1C) of the Rules, as highlighted below:- (i) The value of the asset correlation factor of 0.24 in the correlation (R or ρos) in

the risk-weight functions mentioned in paragraphs 60 and 62 must be replaced by a value of 0.30, and this must remain the case both before and after any adjustment is made to R or ρos pursuant to section 157(5) or 157A of the Rules (see paragraphs 67 and 74).

(ii) If an AI has material IPRE exposures (i.e. the average aggregate EAD of its

reference exposures30 over the past 12 months exceeds 5% of its capital base as determined under Part 3 of the Rules), it must not use the advanced IRB approach in respect of its HVCRE exposures unless the AI also uses the advanced IRB approach to derive the risk-weighted amount of all of its IPRE exposures.

(iii) For an AI that started to use the advanced IRB approach for its HVCRE

exposures at a time when it did not have any material IPRE exposures but which:

(a) subsequently becomes aware that it has material IPRE exposures; and (b) does not also use the advanced IRB approach to derive the risk-weighted

amount of all of its reference exposure,

30 Please see the definition of “reference exposure” under section 158(6) of the Rules for the various sources of IPRE exposures of AIs for this purpose.

MA(BS)3(IIIc) /P.28 (03/2016)

the AI must cease to use the advanced IRB approach in respect of its HVCRE exposures after the expiry of a period of 6 months after the date on which the AI became so aware, unless the AI begins to use the advanced IRB approach for all of its reference exposures within that 6-month period.

74. Subject to paragraph 73, an AI may make a firm-size adjustment as described in

paragraph 66 to an HVCRE exposure that meets the size criteria for SME corporates set out in paragraph 17.

75. In respect of SL under supervisory slotting criteria approach, an AI should apply the

risk-weight specified in the table below for the relevant supervisory rating grade to which a SL is assigned in calculating the risk-weighted amount of that SL.

Strong Good Satisfactory Weak Default

A. SL (other than HVCRE exposures)

(i) Remaining maturity of less than 2.5 years

50% 70% 115% 250% 0%

(ii) Remaining maturity of equal to or

more than 2.5 years

70% 90% 115% 250% 0%

B. HVCRE exposures

(i) Remaining maturity of less than 2.5 years

70% 95% 140% 250% 0%

(ii) Remaining maturity of equal to or

more than 2.5 years

95% 120% 140% 250% 0%

76. An AI may assign a preferential risk-weight of –

(a) 50% to “strong” exposures and 70% to “good” exposures, as set out in row A(i)

of the table above, in respect of its SL (other than HVCRE exposures and specified ADC exposures); and

(b) 70% to “strong” exposures and 95% to “good” exposures, as set out in row B(i)

of the table above, in respect of its HVCRE exposures, provided that the SL has a remaining maturity of less than 2.5 years, or the AI demonstrates to the satisfaction of the MA that the AI’s credit underwriting criteria and the ability of the obligor in respect of the SL to withstand other risk

MA(BS)3(IIIc) /P.29 (03/2016)

characteristics are substantially stronger than the corresponding criteria for the equivalent supervisory rating grade as described in paragraph 16(i).

(h) LSTs arising from OTC derivative transactions, credit derivative contracts and SFTs

77. An AI may calculate the risk-weighted amount of the default risk exposure in respect of LSTs by multiplying the EAD of the exposure by the relevant risk-weight attributable to that exposure determined under the STC approach in accordance with Part 4 of the Rules. However, the positions of such exposures should still be reported in Form MA(BS)3(IIIc).

(B) Credit Risk Components

Probability of Default (PD) 78. For its corporate, sovereign and bank exposures, an AI should rate on an individual

basis each legal entity to which the AI is exposed. In assigning a PD to individual obligors in a connected group, an AI may assign the same obligor grade in respect of exposures to these obligors (such an obligor grade reflects the benefits of group support in accordance with the established policy of the AI and is thus likely to be more favourable than if the individual obligors are rated on a standalone basis), provided the requirements of section 154(d) of the Rules are met. An AI is also required to set out in policies and put into operation a process for the identification of specific wrong-way risk for each legal entity to which the AI is exposed.

79. For corporate31 and bank exposures, the PD of an exposure is the greater of the PD

associated with the internal obligor grade to which that exposure is assigned, or 0.03%. 80. Under the double default framework, PDo and PDg (see paragraph 62) are the PD

associated with the internal obligor grade of the underlying obligor and the credit protection provider, respectively, and both are also subject to the PD floor of 0.03%.

81. For sovereign exposures, the PD of an exposure is the PD associated with the internal

obligor grade to which that exposure is assigned (i.e. without any PD floor). 82. For corporate, sovereign and bank exposures, the PD of an exposure assigned to a

default grade (i.e. a default of the obligor in respect of the exposure has occurred by virtue of section 149(1) or (5A) of the Rules) is 100%.

83. When estimating the PD for an obligor that is highly leveraged or whose assets are

predominantly traded assets, ensure such estimate reflects the performance of the obligor’s assets based on volatilities calibrated to data from periods of significant financial stress. Forms and measures of leverage have proliferated, and will continue

31 In estimating the PD of a holding company which has both consolidated and unconsolidated (i.e. company level) financial statements, an AI should assess the financial strength of the company on both bases. If these two bases suggest two different PDs, the AI should use the higher one.

MA(BS)3(IIIc) /P.30 (03/2016)

to evolve, as a result of financial innovation (in terms of products and trading strategies) and changes in market sentiment. While markets can, and apparently do, have a prevailing “sense” of which counterparties are regarded as “highly leveraged” (e.g. hedge funds and other equivalently highly leveraged financial sector entities), it appears that no market consensus has yet been reached on specific set(s) of definitive quantitative criteria for determining whether a counterparty is highly leveraged. AIs should therefore make their own judgement on whether an obligor should be considered “highly leveraged” in a prudent and consistent manner, having regard to the risk characteristics of their obligors and prevailing market perceptions of them as well as the nature of the markets in which they operate. A similar approach could be deployed in determining whether the assets of a particular counterparty are “predominantly” traded assets.

Loss Given Default (LGD) 84. An AI should provide an estimate of the LGD for each corporate, sovereign and bank

exposure. There are two approaches for deriving this LGD estimate: the foundation IRB approach or the advanced IRB approach.

LGD under foundation IRB approach

(a) Treatment of exposures which are unsecured or secured by non-recognized collateral under foundation IRB approach

85. Subject to paragraphs 87 and 88, for corporate, sovereign and bank exposures, a

senior exposure32 that is unsecured or secured by a non-recognized collateral should be assigned a LGD of 45%.

86. Subject to paragraphs 87 and 88, for corporate, sovereign and bank exposures, a

subordinated exposure33 should be assigned a LGD of 75%.

(b) Treatment of transactions with specific wrong-way risk under foundation IRB approach

87. For default risk exposures in respect of single-name credit default swaps, where the

swaps fall within section 226J(1) of the Rules and those exposures are determined in accordance with section 226J(3) of the Rules, the exposures should be assigned a supervisory estimate of 100% for the LGD.

88. For default risk exposures in respect of transactions that fall within section 226J(4) of

32 A senior exposure means an exposure to an obligor which is not a subordinated exposure. 33 A subordinated exposure means an exposure to an obligor which is lower in ranking, or junior, to other claims against the obligor in terms of the priority of repayment or which will be repaid only after all the senior claims against the obligor have been repaid.

MA(BS)3(IIIc) /P.31 (03/2016)

the Rules, the exposures should be assigned a supervisory estimate of 100% for the LGD if the AI has the MA’s approval to calculate incremental risk charge for the transactions and the determination of the default risk exposures under that section has used existing calculations for incremental risk charge that already contain an LGD assumption.

(c) Recognized collateral under foundation IRB approach 89. The following collateral can be recognized for senior exposures under the foundation

IRB approach:

(i) recognized financial collateral – • includes any collateral which can be recognized under the comprehensive

approach34 to the treatment of collateral under the STC approach;

• but does not include any collateral in the form of real property, or any collateral in the form of debt securities that would fall within the definition of re-securitization exposure in section 2(1) of the Rules if treated as an on-balance sheet exposure; and

(ii) recognized IRB collateral – these include:

• financial receivables which fall within section 205 of the Rules (recognized

financial receivables);

• commercial real estate (recognized CRE) and residential real estate (recognized RRE) which fall within section 206 or 208 of the Rules; and

• physical assets (other than recognized CRE or recognized RRE) which fall within section 207 or 208 of the Rules (other recognized IRB collateral).

(d) Methodology for recognition of recognized financial collateral under foundation IRB approach

90. The methodology for recognition of recognized financial collateral closely follows the

comprehensive approach under the STC approach. The effective LGD (LGD*) applicable to a senior exposure with recognized financial collateral is expressed as follows:

LGD* = LGD x (E* / E)

Where:

LGD = The supervisory estimate of the LGD specified in paragraph 85, 87 or 88, as the case may be, before recognition of recognized financial collateral

34 The simple approach to the treatment of collateral under the STC approach is not available to an AI applying the IRB approach.

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E = EAD of the exposure

E* = Net credit exposure (being the EAD of the exposure after recognition of recognized financial collateral35)

91. E* is calculated as follows:

E* = max {0, [E x (1 + He) - C x (1 - Hc - Hfx)]}

Where: He = Haircut applicable to the exposure pursuant to the standard

supervisory haircuts for the comprehensive approach to treatment of recognized collateral subject to adjustment as set out in section 92 of the Rules

C = Current market value of recognized financial collateral before adjustment required by the comprehensive approach to treatment of recognized collateral

Hc = Haircut applicable to recognized financial collateral pursuant to the standard supervisory haircuts for the comprehensive approach to treatment of recognized collateral subject to adjustment as set out in section 92 of the Rules

Hfx = Haircut applicable in consequence of a currency mismatch (if any) pursuant to the standard supervisory haircuts for the comprehensive approach to treatment of recognized collateral subject to adjustment as set out in section 92 of the Rules

In calculating the net credit exposure (E*), haircuts should be applied to the value of the exposure (He) and the value of the collateral (Hc) for any possible future price fluctuations. Where there is a currency mismatch between the exposure and the collateral, a further haircut (Hfx) should be applied to the collateral to provide allowance for any possible fluctuation in exchange rates. An AI should refer to Annex IIIb-E of the completion instructions of Form MA(BS)3(IIIb) which sets out the standard supervisory haircuts and the circumstances requiring a haircut adjustment (i.e. based on the frequency of remargining or revaluation) under the comprehensive approach. Where there is maturity mismatch between the exposure and the collateral, the AI should adjust the value of the collateral in accordance with paragraphs 230 to 232.

92. As in the STC approach, a 0% haircut is applied to repo-style transactions that are

treated as collateralized loans to the counterparty if the criteria for the preferential treatment under the comprehensive approach as set out in Annex IIIb-D of the completion instructions of Form MA(BS)3(IIIb) are satisfied.

35 This concept is only applied to the calculation of LGD*. An AI should continue to calculate EAD without taking into account the presence of any collateral, unless otherwise specified.

MA(BS)3(IIIc) /P.33 (03/2016)

(e) Methodology for recognition of recognized IRB collateral under foundation IRB approach

93. The methodology for determining the LGD* of a senior exposure under the

foundation IRB approach for cases where an AI has taken recognized IRB collateral is set out as follows:

(i) exposures where the ratio of the current market value of the collateral received

(C) to the EAD of the exposure (E) is below a threshold level of C* (i.e. the required minimum collateralization level for the exposure) will be treated as an unsecured exposure subject to a LGD specified in paragraph 85, 87 or 88, as the case may be; and

(ii) exposures where the ratio of (C) to (E) exceeds another threshold level of C**

(i.e. the required level of over-collateralization for full LGD recognition) will be assigned a LGD according to the table below:

Recognized IRB

collateral Supervisory estimate of

LGD

Required minimum

collateralization for partial

recognition (C*)

Required level of over-

collateralization for full recognition

(C**)

Recognized financial receivables 35% 0% 125%

Recognized CRE/ RRE 35% 30% 140%

Other recognized IRB collateral 40% 30% 140%

94. Under the foundation IRB approach, if the ratio of C to E of a senior exposure

exceeds a threshold of level C* but not a threshold of level C**, the LGD* for the collateralized and uncollateralized portions of the exposure is determined as follows:

(i) the part of the exposure considered to be fully collateralized (i.e. C/C**)

receives the LGD associated with the type of collateral according to the table in paragraph 93; and

(ii) the remaining part of the exposure is regarded as uncollateralized (i.e. E - C/C**)

and receives a LGD specified in paragraph 85, 87 or 88, as the case may be.

(f) Methodology for recognition of pools of recognized collateral under foundation IRB approach

95. The methodology for determining the LGD* of an exposure under the foundation IRB

approach for cases where an AI has taken both recognized financial collateral and recognized IRB collateral is aligned with the treatment in the STC approach and based on the following guidance:

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(i) where an AI has obtained multiple forms of collateral recognized under the foundation IRB approach for an exposure, the AI should divide the exposure into:

• the portion fully collateralized by recognized financial collateral (after

taking into account various haircuts and the adjustment for maturity mismatch in determining the value of the recognized financial collateral);

• the portion fully collateralized by recognized financial receivables;

• the portion fully collateralized by recognized CRE/RRE;

• the portion fully collateralized by other recognized IRB collateral;

• the portion, if any, which is uncollateralized.

(ii) where the ratio of the sum of the current market value of recognized CRE/RRE

and other recognized IRB collateral to the remaining EAD of the exposure (i.e. after taking into account the credit risk mitigating effect of recognized financial collateral and recognized financial receivables) is below the threshold level C* (i.e. 30%), the AI should assign a LGD specified in paragraph 85, 87 or 88, as the case may be, to the remaining exposure.

(iii) the AI should calculate the risk-weighted amount of each fully secured portion

of exposure separately.

LGD under Advanced IRB Approach 96. Except for the exposures specified in paragraph 97, an AI using the advanced IRB

approach is allowed to use its own internal estimates of LGD for corporate, sovereign and bank exposures. The LGD should be measured as a percentage of the EAD.

97. For a facility type that comprises default risk exposures in respect of single-name

credit default swaps that fall within the description of paragraph 87 or transactions that fall within the description of paragraph 88, an AI must comply with the requirements of the applicable paragraph as if the institution were an AI that uses the foundation IRB approach.

LGD under Double Default Framework

98. For the purposes of calculating the risk-weighted amount of hedged exposures under

the double default framework, LGDg is the LGD of a comparable direct exposure to the credit protection provider (see paragraph 62). That means, LGDg will be the LGD of the exposure to the credit protection provider or an unhedged exposure to the underlying obligor, depending upon whether in the event both the credit protection provider and the underlying obligor default during the life of the hedged exposure, available evidence and the structure of the guarantee/credit derivative contract indicate that the amount recovered would depend on the financial condition of the credit protection provider or the underlying obligor, as the case may be.

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99. In estimating the LGDg, an AI may recognize collateral provided exclusively against the exposure or the guarantee/credit derivative contract respectively. There should be no consideration of double recovery in the LGD estimate.

Exposure at Default (EAD) 100. The EAD of an exposure is measured without deduction of specific provisions and

partial write-offs. 101. In relation to an on-balance sheet exposure, an AI should use the current drawn

amount of the exposure (for an exposure that is measured at fair value, the current drawn amount is the value determined in accordance with section 4A of the Rules), after taking into account the credit risk mitigating effect of any recognized netting (see Part XIII of this section), as an estimate of the EAD of the exposure such that the EAD of the exposure is not less than the sum of:

(i) the amount by which the AI’s CET1 capital would be reduced if the exposure

were fully written-off; and

(ii) any specific provisions and partial write-offs in respect of the exposure.

Where the amount by which an AI’s estimate of EAD in respect of an exposure exceeds the sum of items (i) and (ii) of the exposure, this amount is termed a discount. The calculation of the risk-weighted amount should be independent of any discounts. In calculating the eligible provisions for the purpose of the EL-eligible provisions calculation as set out in Section C, any discounts attributed to defaulted exposures should be included.

102. In relation to the calculation of EAD of off-balance sheet exposures, an AI should

refer to Part XII of this section.

Effective Maturity (M)

(a) M under foundation IRB approach 103. For an AI using the foundation IRB approach for corporate, sovereign and bank

exposures, M will be 2.5 years except for repo-style transactions where M will be 6 months36.

(b) M under advanced IRB approach 104. An AI using the advanced IRB approach for corporate, sovereign and bank exposures

is required to calculate M for each exposure. Subject to paragraph 105, M is defined 36 With the prior consent of the MA, an AI using the foundation IRB approach may calculate M for each exposure in accordance with paragraphs 104 to 106 if the AI can demonstrate that it has adequate systems for doing so.

MA(BS)3(IIIc) /P.36 (03/2016)

as the greater of one year or the remaining effective maturity, in years, of the exposure as defined below:

(i) subject to items (ii), (iii) and (iv), for an exposure subject to a predetermined

cash flow schedule, M is defined as:

M = ∑∑t

ttt

CFCFt /*

where CFt denotes cash flows (including principal, interest payments and fees) contractually payable by the obligor in period t. Period t is expressed in years (that is, where a payment is due to be received in 18 months, t = 1.5);

(ii) if the exposure is a default risk exposure in respect of a netting set calculated

using the IMM(CCR) approach and the original maturity of the longest-dated contract contained in the netting set is greater than one year, the M of the exposure is calculated by:

∑

∑ ∑≤

=

≤

= >

×∆×

×∆×+×∆×= yeart

kkk

yeart

k

maturity

yeartkkkkk

k

k

k

dft

dftEEdftM 1

1k

1

1 1 k

EEEffective

EEEffective

Where –

dfk is the risk-free discount factor for future time period tk;

Effective EEk = effective EE at time tk calculated in accordance with section 226G of the Rules;

maturity = the time when the transaction which has the longest residual maturity in the netting set matures; and

1−−=∆ kkk ttt is the time interval between tk and tk-1 when EE is calculated at dates that are not equally spaced over time;

(iii) subject to item (iv),

• if the exposure is a default risk exposure in respect of a netting set calculated using the IMM(CCR) approach and all the transactions in the netting set have an original maturity of not more than one year, the effective maturity of each transaction in the netting set is calculated by the use of the formula under item (i), and the effective maturity of the netting set is calculated as the weighted average effective maturity of the transactions (using the notional amount of each transaction for weighting the maturity of the transactions within the netting set); and

• if the netting set referred to in the bullet above contains only one transaction,

the M of the exposure is calculated by the use of the formula under item (i);

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(iv) if it is not practicable for an AI to calculate M of the contracted payments in

accordance with item (i) or (iii), the AI should use a more prudent measure of M which is not less than the maximum remaining time, in years, that the obligor is permitted to take to fully discharge its contractual obligations (including principal payments, interest payments and fees) under the terms of the agreement governing the exposure. This usually corresponds to the nominal maturity of the exposure; and

(v) subject to items (ii) and (iii), if an exposure is a net credit exposure resulting

from the netting of more than one nettable OTC derivative transaction or credit derivative contract, the weighted average maturity of the transactions or contracts (using the notional amount of each transaction or contract for weighting the maturity of the transactions or contracts) subject to a valid bilateral netting agreement is used as the M but the M must be not less than one year.

In all cases, M will be no greater than five years.

105. The one-year floor does not apply to the follo